Italy's Target-2 balances worsen

Central bank data indicate capital outflow

by Frank Westermann, Osnabrück University

Fri 10 Oct 2014

Since summer 2012 when the European Central Bank calmed markets with its Outright Monetary Transactions bond-buying programme, Target-2 balances showing intra-central bank debits and credits within the euro area have fallen gradually and smoothly. But Italy has taken a different turn. Within two months, its Target-2 liabilities to the rest of the euro area have increased by €67bn. This is a very large amount, comparable to the period from mid-2011 to March 2012 when Italian Target-2 liabilities increased about €30bn per month on average.

But why have the balances worsened for Italy, and not for other financially-stretched countries? Data from the Euro Crisis Monitor – maintained by the Institute of Empirical Economic Research at Osnabrück University – show no unusual movements for other countries, for example in Spain, where the balances have shown constant improvement. Germany on the other hand has displayed an increase of €36bn in its credit balance in the past two months.

Several issues need to be taken into consideration when explaining Italy’s recent pattern. First, in Italy there has not been substantial progress on economic reforms. And to the extent that reforms have taken place, they have not had a sizable impact on economic fundamentals, such as prices relative to the rest of the euro area, the debt ratio or unemployment rates.

However, this is hardly news specific to August and September. To understand the recent increase, it is important to take into account the factors that drove up Target-2 balances in the first place: A wave of capital flight that was triggered when the ECB reduced its collateral standards throughout 2011, in particular on 8 December. On this day, the ECB decided that banks could borrow against collateral from their national central banks for a three year period.

Italian banks were strongly involved in these long term refinancing operations. While part of it has been repaid, about half still remains on the Bank of Italy’s balance sheet, and the collateral is still earmarked on the balance sheets of the banks. It is important to keep in mind that the two rounds of LTROs will expire in December this year and February next year.

But, again, why Italy and not the other countries? A possible explanation may be found in the details of the OMT programme, which provides implicit insurance only to those countries that are under a European Financial Stability Facility or European Stability Mechanism programme and that have accepted the associated conditionality. To be eligible, Italy would have to make a formal request and start negotiations on the ESM. The apparent new wave of capital outflows from Italy might reflect market expectations that such negotiations would be cumbersome in the presence of constitutional concerns in Germany, the forthcoming bank stress-test by the ECB and increasing electoral opposition on all sides.

Frank Westermann is professor of Economics at Osnabrück University, and a member of the OMFIF Advisory Board.